Category Archives: Janet Yellen outlook

Miles Kimball is a Professor at the University of Michigan, and a vocal and prolific proponent of negative interest rates. His Confessions of a Supply-Side Liberal is peppered with posts on the benefits of negative interest rates.

First, negative interest rates central bank charge member banks on reserves should be passed onto commercial and consumer customers with larger accounts – perhaps with an exemption for smaller checking and savings accounts with, say, less than $1000.

Second, moving toward electronic money in all transactions makes administration of negative interest rates easier and more effective. In that regard, it may be necessary to tax transactions conducted in paper money, if a negative interest rate regime is in force.

Third, impacts on bank profits can be mitigated by providing subsidies to banks in the event the central bank moved into negative interest rate territory.

Fundamentally, Kimball’s view is that.. monetary policy–and full-scale negative interest rate policy in particular–is the primary answer to the problem of insufficient aggregate demand. No need to set inflation targets above zero in order to get the economy moving. Just implement sufficiently negative interest rates and things will rebound quickly.

Kimball’s vulnerability is high mathematical excellence coupled with a casual attitude toward details of actual economic institutions and arrangements.

For example, in his Carney post, Kimball offers this rather tortured prose under the heading -“Why Wealth Effects Would Be Zero With a Representative Household” –

It is worth clarifying why the wealth effects from interest rate changes would have to be zero if everyone were identical [sic, emphasis mine]. In aggregate, the material balance condition ensures that flow of payments from human and physical capital have not only the same present value but the same time path and stochastic pattern as consumption. Thus–apart from any expansion of the production of the economy as a whole as a result of the change in monetary policy–any effect of interest rate changes on the present value of society’s assets overall is cancelled out by the effect of interest rate changes on the present value of the planned path and pattern of consumption. Of course, what is actually done will be affected by the change in interest rates, but the envelope theorem says that the wealth effects can be calculated based on flow of payments and consumption flows that were planned initially.

That’s in case you worried a regime of -2 percent negative interest rates – which Kimball endorses to bring a speedy end to economic stagnation – could collapse the life insurance industry or wipe out pension funds.

And this paragraph is troubling from another standpoint, since Kimball believes negative interest rates or “monetary policy” can trigger “expansion of the production of the economy as a whole.” So what about those wealth effects?

Indeed, later in the Carney post he writes,

..for any central bank willing to go off the paper standard, there is no limit to how low interest rates can go other than the danger of overheating the economy with too strong an economic recovery. If starting from current conditions, any country can maintain interest rates at -7% or lower for two years without overheating its economy, then I am wrong about the power of negative interest rates. But in fact, I think it will not take that much. -2% would do a great deal of good for the eurozone or Japan, and -4% for a year and a half would probably be enough to do the trick of providing more than enough aggregate demand.

Although not completely fair, I have to say all this reminds me of a widely-quoted passage from Keynes’ General Theory –

“Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”

Of course, the policy issue behind the spreading adoption of negative interest rates is that the central banks of the world are, in many countries, at the zero bound already. Thus, unless central banks can move into negative interest rate territory, governments are more or less “out of ammunition” when it comes to combatting the next recession – assuming, of course, that political alignments currently favoring austerity over infrastructure investment and so forth, are still in control.

The problem I have might be posed as one of “complexity theory.”

I myself have spent hours pouring over optimal control models of consumption and dynamic general equilibrium. This stuff is so rarified and intellectually challenging, really, that it produces a mindset that suggests mastery of Portryagin’s maximum principle in a multi-equation setup means you have something relevant to say about real economic affairs. In fact, this may be doubtful, especially when the linkages between organizations are so complex, especially dynamically.

The problem, indeed, may be institutional but from a different angle. Economics departments in universities have, as their main consumer, business school students. So economists have to offer something different.

One would hope machine learning, Big Data, and the new predictive analytics, framed along the lines outlined by Hal Varian and others, could provide an alternative paradigm for economists – possibly rescuing them from reliance on adjusting one number in equations that are stripped of the real, concrete details of economic linkages.

It is widely expected the US Federal Reserve Bank will raise the federal funds rate from its seven-year low below 0.25 percent to maybe 0.50 percent. Then, further increases will bring this key short term rate back in line with its historic profile gradually, depending on the health of the US economy and international factors.

This will probably occur next week at the meeting of the Federal Open Market Committee (FOMC), December 15-16.

Here’s a chart from the excellent St. Louis Federal Reserve data site (FRED) showing how unusual recent years are in terms of this key interest rate.

Shading in the chart indicates periods of recession.

Thus, the federal funds rate – which is the rate charged on overnight loans to banking members of the Federal Reserve system – was pushed to the zero bound as a response to the financial crisis and recession 2008-2009.

Yet discussion still considers the balance between ‘doves’ and ‘hawks’ on the FOMC. Next year, apparently, FOMC membership may shift toward more ‘hawks’ in voting positions – bankers who see inflation risks from the current recovery. See, for example, Richard Grossman’s Birdwatching at the Federal Reserve.

As a result, our only question for the upcoming Fed rate hike is how long it will take before the Fed, shortly after increasing rates by a modest 25 bps to “prove” to itself if not so much anyone else that the US economy is fine, will be forced to mainline trillions of dollars around the globe via swap lines for the second time in a row as the world experiences the biggest USD margin call in history.

By the end of next week or probably just after the first of 2016, interest rates may move a little from the zero bound, and from then on, one fulcrum of all business and economic forecasts will be the pace of further increases.

For my money, Janet Yellen’s speech July 10 – parts of which I quote below – is important.

Yellen says the Fed plans the first increase in interest rates this year – in September or December, given Fed meeting schedules.

I believe the fact that we have virtually zero interest rates, and have for some time, creates distortions in economic discussions, not to mention its bizarre effects on the real economy.

On the one hand, the US Federal Reserve must realize that if it does not raise interest rates in this phase of the business cycle, it may be a very long time before we get off the zero lower bound. This creates a tendency to “happy talk” from monetary officials, although not Ms. Yellen specifically, papering over weakness in the US and global economy.

On the other hand, I suspect there are now economic interests invested in continuation of low rates, and their contribution going forward may be to sound the alarm at the slightest sign of economic troubles.

And, truly, this expansion phase of the current business cycle is “growing long in the tooth.” It began, according to the National Bureau of Economic Research, in summer 2009. This makes for 96 months from the previous trough of the business cycle to the current time. Only two previous US business expansions historically are longer than this, and only by one or two years.

The price of (economic) freedom is eternal vigilance. With that in mind, consider some of the datapoints on the current economic outlook.

United States

There is an extensive extract from Ms. Yellen’s speech, assessing US economic conditions, the latest report indicating retail sales softened, and the earlier May 2015 consensus forecast of the Survey of Professional Forecasters, indicating lower economic growth expectations.

Let me turn now to where I think the economy is headed over the next several years. The latest estimates show that both real GDP and industrial production actually edged down in the first quarter of this year. Some of this weakness appears to be the result of factors that I expect will be only transitory, such as the unusually harsh winter weather in some regions of the country and the West Coast port labor dispute that briefly restrained international trade and caused disruptions in manufacturing supply chains. Also, statistical noise or measurement issues may have played some role. This is not the first time in recent years that real GDP has been reported to decline, or grow unusually slowly, in the first quarter of the year. There is a healthy debate among economists–many within the Federal Reserve System–about some of the technical factors that may lie behind this pattern.4 Nevertheless, at least a couple of other more persistent factors also likely weighed on economic output and industrial production in the first quarter. In particular, the higher foreign exchange value of the dollar that I mentioned, as well as weak growth in some foreign economies, has restrained the demand for U.S. exports. Moreover, lower crude oil prices have significantly depressed business investment in the domestic energy sector. Indeed, industrial production continued to decline somewhat in April and May. We expect the drag on domestic economic activity from these factors to ease over the course of this year, as the value of the dollar and crude oil prices stabilize, and I anticipate moderate economic growth, on balance, for this year as a whole. As always, however, the economic outlook is uncertain. Notably, although the economic recovery in the euro area appears to have gained a firmer footing, the situation in Greece remains unresolved.

Looking further ahead, I think that many of the fundamental factors underlying U.S. economic activity are solid and should lead to some pickup in the pace of economic growth in the coming years. In particular, I anticipate that employment will continue to expand and the unemployment rate will decline further.

An improving job market should, in turn, help support a faster pace of household spending growth. Additional jobs and potentially faster wage growth bolster household incomes, and lower energy prices mean consumers have more money to spend on other goods and services. In addition, growing employment and wages should make consumers more comfortable in spending a greater portion of their incomes than they have been in the aftermath of the Great Recession. Moreover, increases in house values and stock market prices, along with reductions in debt in recent years, have pushed up households’ net worth, which also should support more spending. Finally, interest rates faced by borrowers remain low, reflecting the FOMC’s highly accommodative monetary policies. Indeed, recent encouraging data about retail sales and light motor vehicle purchases in the beginning of the second quarter could be an indication that the pace of consumer spending is picking up.

Another positive factor for the outlook is that the drag on economic growth in recent years from changes in federal fiscal policies appears to have waned. Temporary fiscal stimulus measures supported economic output during the recession and early in the recovery, but those stimulus measures have since expired, and additional policy actions were taken to reduce the federal budget deficit. By 2011, these changes in fiscal policies were holding back economic growth. However, the effects of those fiscal policy actions now seem to be mostly behind us.5

There are a couple of factors, however, that I expect could restrain economic growth. First, business owners and managers remain cautious and have not substantially increased their capital expenditures despite the solid fundamentals and brighter prospects for consumer spending. Businesses are holding large amounts of cash on their balance sheets, which may suggest that greater risk aversion is playing a role. Indeed, some economic analysis suggests that uncertainty about the strength of the recovery and about government economic policies could be contributing to the restraint in business investment.6

A second factor that could restrain economic growth regards housing. While national home prices have been rising for a few years and home sales have improved recently, residential construction has remained quite soft. Many households still find it difficult to obtain mortgage credit, but, more generally, the weak job market and slow wage gains in recent years appear to have induced people to double-up on housing. For example, many young adults continue to live with their parents. Population growth is creating a need for more housing, whether to rent or to own, and I do expect that continuing job and wage gains will encourage more people to form new households. Nevertheless, activity in the housing sector seems likely to improve only gradually.

Regarding inflation, as I mentioned earlier, the recent effects of lower prices for crude oil and for imports on overall inflation are expected to wane during this year. Combined with further tightening in labor and product markets, I expect inflation will move toward the FOMC’s 2 percent objective over the next few years. Importantly, a number of different surveys indicate that longer-term inflation expectations have remained stable even as recent readings on inflation have fallen. If inflation expectations had not remained stable, I would be more concerned because consumer and business expectations about inflation can become self-fulfilling.

From the New York Times – To my ears, most of Ms. Yellen’s speech expertly laid out why the economy is not ready for interest rate increases anytime soon. Then, toward the end, she said that based on her views, she expected to begin raising rates “at some point later this year.” That would mean a rate hike in three months, at the Fed’s next meeting in September, or six months hence at its December meeting.

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for June, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $442.0 billion, a decrease of 0.3 percent (±0.5%)* from the previous month, but up 1.4 percent (±0.9%) above June 2014. Total sales for the April 2015 through June 2015 period were up 1.7 percent (±0.7%) from the same period a year ago. The April 2015 to May 2015 percent change was revised from +1.2 percent (±0.5%) to +1.0 percent (±0.3%).

Retail trade sales were down 0.3 percent (±0.5%)* from May 2015, but up 0.6 percent (±0.7%)* above last year. Food services and drinking places were up 7.7 percent (±3.3%) from June 2014 and sporting goods, hobby, books and music were up 6.6 percent (±1.9%) from last year. Gasoline stations were down 17.1% (±1.4%) from the previous year.

The outlook for growth in the U.S. economy over the next three years looks weaker now than it did in February, according to 44 forecasters surveyed by the Federal Reserve Bank of Philadelphia. The forecasters predict real GDP will grow at an annual rate of 2.5 percent this quarter and 3.1 percent next quarter. On an annual-average over annual-average basis, real GDP will grow 2.4 percent in 2015, down 0.8 percentage point from the previous estimate. The forecasters predict real GDP will grow 2.8 percent each in 2016 and 2017, and 2.5 percent in 2018.

Global

Emerging markets made up some of the slack in the global economy after 2008-2009, but today are everywhere slowing, as the latest revision of the International Monetary Fund (IMF) World Economic Outlook indicates.

Global growth is projected at 3.3 percent in 2015, marginally lower than in 2014, with a gradual pickup in advanced economies and a slowdown in emerging market and developing economies. In 2016, growth is expected to strengthen to 3.8 percent.

A setback to activity in the first quarter of 2015, mostly in North America, has resulted in a small downward revision to global growth for 2015 relative to the April 2015 World Economic Outlook (WEO). Nevertheless, the underlying drivers for a gradual acceleration in economic activity in advanced economies—easy financial conditions, more neutral fiscal policy in the euro area, lower fuel prices, and improving confidence and labor market conditions—remain intact.

In emerging market economies, the continued growth slowdown reflects several factors, including lower commodity prices and tighter external financial conditions, structural bottlenecks, rebalancing in China, and economic distress related to geopolitical factors. A rebound in activity in a number of distressed economies is expected to result in a pickup in growth in 2016.

The distribution of risks to global economic activity is still tilted to the downside. Near-term risks include increased financial market volatility and disruptive asset price shifts, while lower potential output growth remains an important medium-term risk in both advanced and emerging market economies. Lower commodity prices also pose risks to the outlook in low-income developing economies after many years of strong growth.

My take is that the harsh dealing with Greece led by, apparently, the Germans is more symbolic than directly material to global economic conditions. Nevertheless, it is an ugly symbol, representing, it seems, the end of dreamy thoughts about European integration and the onset of recognition of new German hegemony in Europe.

I am an admirer of modern Germany, having struggled to relearn enough German to read newspapers recently and ask for items in German bakeries. I see the German perspective, but I deeply regret its narrow scope. I think more conservative Germans are missing the big picture here. Of course, the plight of the Greeks is desperate and lamentable.

One final remark – forecasting comes to the fore at junctures such as these. Are we on the cusp, have we started to slide down, or is there still some upside? Compelling questions.

“The Fed may get more raucous about what to do next as tapering draws to a close,” Alan Blinder, a banking industry consultant and economics professor at Princeton University said in a speech to the Investment Management Consultants Association in Boston.

The cacophony is likely to “rattle the markets” beginning in late summer as traders debate how precipitously the Fed will turn from reducing its purchases of U.S. government debt and mortgage securities to actively selling it.

The Open Market Committee will announce its strategy in October or December, he said, but traders will begin focusing earlier on what will happen with rates as some members of the rate-setting panel begin openly contradicting Fed Chair Janet Yellen, he said.

Then, there are some other assorted links with good infographics, charts, or salient discussion.

Turkey’s Institutions Problem from the Stockholm School of Economics, nice infographics, visual aids. Should go along with your note cards on an important emerging economy.

Post-Crash economics clashes with ‘econ tribe’ – economics students in England are proposing reform of the university economics course of study, but, as this link points out, this is an uphill battle and has been suggested before.

Traditionally, gold is considered a hedge against uncertainty. Indulge your imagination and it’s not hard to conjure up scary scenarios in the Ukraine. On the other hand, some interpret Yellen as signaling an earlier move to moving the Federal funds rate off zero, increasing interest rates, and, in the eyes of the market, making gold more expensive to hold.

Multivariate Forecasting Models of Gold Price – Some Considerations

It’s this zoo of factors and influences that you have to enter, if you want to try to forecast the price of gold in the short or longer term.

A lot of effort has been devoted to proving or attempting to question that gold is a hedge against inflation.

The bottom line appears to be that gold prices rise with inflation – over a matter of decades, but in shorter time periods, intervening factors can drive the real price of gold substantially away from a constant relationship to the overall price level.

Real (and possibly nominal) interest rates are a significant influence on gold prices in shorter time periods, but this relationship is complex. My reading of the literature suggests a better understanding of the supply side of the picture is probably necessary to bring all this into focus.

The story here is that gold mine production responds to real interest rates, and thus the semi-periodic fluctuations in real interest rates are linked with a cycle of growth in gold production.

The Goldman Sachs Paper 183 suggests that higher real interest rates speed extraction, since the opportunity cost of leaving ore deposits in the ground increases. This is indeed the flip side of the negative impact of real interest rates on investment.

And, as noted in an earlier post,the Goldman Sachs forecast in 2010 proved prescient. Real interest rates have remained low since that time, and gold prices drifted down from higher levels at the end of the last decade.

Elasticities

Elasticities of response in a regression relationship show how percentage changes in the dependent variable – gold prices in this case – respond to percentage changes in, for example, the price level.

For gold to be an effective hedge against inflation, the elasticity of gold price with respect to changes in the price level should be approximately equal to 1.

This appears to be a credible elasticity for the United States, based on two studies conducted with different time spans of gold price data.

These studies explore the cointegration of gold prices and inflation. Cointegration of unit root time series is an alternative to first differencing to reduce such time series to stationarity.

Thus, it’s not hard to show strong evidence that standard gold price series are one type or another of a random walk. Accordingly, straight-forward regression analysis of such series can easily lead to spurious correlation.

You might, for example, regress the price of gold onto some metric of the cumulative activity of an amoeba (characterized by Brownian motion) and come up with t-statistics that are, apparently, statistically significant. But that would, of course, be nonsense, and the relationship could evaporate with subsequent movements of either series.

So, the better research always gives consideration to the question of whether the variables in the models are, first of all, nonstationary OR whether there are cointegrated relationships.

Thus, instead of viewing gold as a special asset, the authors suggest it is more reasonable to view gold as another currency, whose value is a reflection of the value of U.S. dollar.

The authors consider and reject a variety of hypotheses – such as the safe haven or consumer fear motivation to hold gold. They find a very significant relationship between the price movement of gold, real interest rates and the exchange rate, suggesting a close relationship between gold and the value of U.S. dollar. The multiple linear regressions verify these findings.

The Bottom Line

Over relatively long time periods – one to several decades – the price of gold moves more or less in concert with measures of the price level. In the shorter term, forecasting faces serious challenges, although there is a literature on the multivariate prediction of gold prices.

One prediction, however, seems reasonable on the basis of this review. Real interest rates should rise as the US Federal Reserve backs off from quantitative easing and other central banks around the world follow suit. Thus, increases in real interest rates seem likely at some point in the next few years. This seems to indicate that gold mining will strive to increase output, and perhaps that gold mining stocks might be a play.

The World Bank issued its latest Global Economic Prospects report this week, basically offering up a forecast based on dynamics of (a) moderate increases in growth in the US and Europe (assuming no abrupt, but a gradual taper of QE), and (b) slowing, but stable growth in the developing world at a pace still about double that of the “developed” countries.

The story is, as with other macroeconomic forecasts issued recently by investment banks, that constraints, such as the fiscal drag on growth are being loosened, both in the US and in Europe. With currently low interest rates and continuing excess capacity, this suggests more rapid economic US and EU growth in 2014. Together with the still high average rates of growth in China and elsewhere, this suggests to the World Bank economists, that global growth will quicken in 2014.

Here is a World Bank spokesman with the basic story of the new Global Economic Prospects release.

And here are some of the specific numbers in the report (click to enlarge).

Her reference to equity-risk premiums sent me to Aswath Damodaran’s webpage, which estimates this metric -basically the extra return investors demand to lure them into stocks and out of the safety of government bonds (in the Updated Data section). It’s definitely an implied value, so it’s hard to judge.

But what are some of the other Pro’s and Con’s regarding a stock market bubble?

Pros – There Definitely is a Bubble

The CAPE (cylically adjusted price earnings ratio) is approaching 2007 levels. This is a metric developed by Robert Shiller and, according to him, is supposed to be a longer term indicator, rather than something that can signal short-term movements in the market. At the same time, recent interviews, who recently shared a Nobel prize in economics, indicate Shiller is currently ‘most worried’ about ‘boom’ in U.S. stock market. Here is his CAPE indext (click this and the other charts here to enlarge).

Several sector and global bubbles are currently reinforcing each other. When one goes pop, it’s likely to bring down the house of cards. In the words of Jesse Columbo, whose warnings in 2007 were prescient,

..the global economic recovery is actually what I call a “Bubblecovery” or a bubble-driven economic recovery that is driven by inflating post-2009 bubbles in China, emerging markets, Australia, Canada, Northern and Western European housing, U.S. housing, U.S. healthcare, U.S. higher education, global bonds, and tech (Web 2.0 and social media).

Margin debt, as reported by the New York Stock Exchange, is also at its all-time highs. Here’s a chart from Advisor Perspectives adjusting margin debt for inflation over a long period.

The S&P 500, adjusted for inflation, has not reached the peaks of either 2000 or2007 (chart from All Start Charts)

Bottom Line

I must confess, doing the research for the post, that I think the stock market in the US may have a ways to go, before it hits its peak this time. Dr. Yelen’s appointment suggests quantitative easing (QE) and low interest rates may continue for some time, before the Fed takes away the punch bowl. My guess is that markets are just waiting at this point to see whether this is, in fact, what is likely to happen, or whether others in the Fed will exercise stronger control over policy, now Ben Bernacke is gone.

And, as seems probable, Yellen consolidates her control and signals continuation of current policies, then I suspect we will see some wild increases in asset values here and globally.